FINANCIAL POSITION

If you borrow money from a bank, you have to list the value of all of your
significant assets, as well as all of your significant liabilities. Your bank uses this
information to assess the strength of your financial position; it looks at the quality
of the assets, such as your car and your house, and places a
conservative valuation upon them. The bank also ensures that all liabilities, such
as mortgage and credit card debt, are appropriately disclosed and fully valued.
The total value of all assets less the total value of all liabilities gives your net
worth or equity. 

Evaluating the financial position of a listed company is similar, except investors

need to take another step and consider that financial position in relation
to market value. Let's take a look.

The Balance Sheet

Like your financial position, a company's financial situation is defined by its
assets and liabilities. A company's financial position also includes shareholder
equity. All of this information is presented to shareholders in the balance sheet.1

Suppose that we are examining the financial statements of the fictitious publicly
listed retailer The Outlet to evaluate its financial position. To do this, we review
the company's annual report, which can often be downloaded from a company's
website. The standard format for the balance sheet is assets, followed by
liabilities, then shareholder equity. 

Current Assets and Liabilities

On the balance sheet, assets and liabilities are broken into current and non-
current items. Current assets or current liabilities are those with an expected life
of fewer than 12 months. For example, suppose that the inventories that The
Outlet reported as of Dec. 31, 2018, are expected to be sold within the following
year, at which point the level of inventory will fall, and the amount of cash will
rise.

Like most other retailers, The Outlet's inventory represents a significant

proportion of its current assets, and so should be carefully examined. Since
inventory requires a real investment of precious capital, companies will try to
minimize the value of a stock for a given level of sales, or maximize the level of
sales for a given level of inventory. So, if The Outlet sees a 20% fall in inventory
value together with a 23% jump in sales over the prior year, this is a sign they are
managing their inventory relatively well. This reduction makes a positive
contribution to the company's operating cash flows.
Current liabilities are the obligations the company has to pay within the coming
year and include existing (or accrued) obligations to suppliers, employees, the
tax office, and providers of short-term finance. Companies try to manage cash
flow to ensure that funds are available to meet these short-term liabilities as they
come due.1

The Current Ratio

The current ratio—which is total current assets divided by total current liabilities
—is commonly used by analysts to assess the ability of a company to meet its
short-term obligations. An acceptable current ratio varies across industries, but
should not be so low that it suggests impending insolvency, or so high that it
indicates an unnecessary build-up in cash, receivables, or inventory. Like any
form of ratio analysis, the evaluation of a company's current ratio should take
place in relation to the past.

Non-Current Assets and Liabilities

Non-current assets or liabilities are those with lives expected to extend beyond
the next year. For a company like The Outlet, its biggest non-current asset is
likely to be the property, plant, and equipment the company needs to run its
business.

Long-term liabilities might be related to obligations under property, plant, and

equipment leasing contracts, along with other borrowings. 

Financial Position: Book Value

If we subtract total liabilities from assets, we are left with shareholder equity.
Essentially, this is the book value, or accounting value, of the shareholders' stake
in the company. It is principally made up of the capital contributed by
shareholders over time and profits earned and retained by the company,
including that portion of any profit not paid to shareholders as a dividend.